All you ever wanted to know about short-selling
Published 13/08/2011 | 05:00
What is short-selling?
If you think a share price is going to fall, you borrow the shares from a shareholder for a fixed period. You then sell those shares at the current market price.
At the end of the loan period, you must then buy back the shares to return them to their original owner. If you were right and the share price has fallen, it will cost you much less to buy back the shares.
Why is this a bad thing?
If it is known that there are a lot of short-sellers in the market it tends to drive down the share price because as soon as the short-sellers borrow the shares from their original owners they sell them. The presence of short-sellers in the market artificially boosts the volume of shares being sold and drives prices down even further than might otherwise be the case.
What is naked short-selling?
No, you don't need to provide your credit card details before engaging in this activity. While most short-sellers borrow the shares first, "naked" short-sellers don't do this, betting instead that the share price will fall between the time they agree to sell the shares and the time, a few weeks later, when they have to settle up with their broker and actually produce the shares.
Unlike conventional short-selling, which is supported by most professional investors, "naked" short-selling is widely frowned upon and is effectively illegal in the United States.
This short-selling lark looks like money for old rope. What are the risks?
The big risk for all short-sellers is that the share price rises instead of falls. If this happens, the short-sellers can lose a fortune as they have to go out into the market and repurchase the shares at a much higher price.
Short-sellers are also vulnerable to what is known as a "short squeeze". This happens when other investors become aware that there are a lot of short-sellers coming to the end of a loan period. They bid up the share price, thus "squeezing" the short-sellers. Couldn't happen to a nicer bunch of people.
Do bans on short-selling work?
Except in the very short-term almost certainly not. The short-selling of Irish bank shares was banned after the "St Patrick's Day Massacre" of March 2008. It didn't do any good with Anglo being nationalised and its shareholders being wiped out less than a year later, while the share prices of the other Irish banks also fell to virtually nothing.
Doesn't shorting create enormous incentives for abuse?
Short-sellers certainly have an interest in seeing shares they have "shorted" falling. There is plenty of anecdotal evidence of short-sellers spreading damaging rumours about companies they have "shorted".